n05 - Chapter 6 Notes Page 1 Cost-Volume-Profit Analysis...

Chapter 6 Notes Page 1 Please send comments and corrections to me at [email protected]Cost-Volume-Profit Analysis Understanding the relationship between a firm’s costs, profits and its volume levels is very important for strategic planning. When you are considering undertaking a new project, you will probably ask yourself, “How many units do I have to produce and sell in order to Break Even?” The feasibility of obtaining the level of production and sales indicated by that answer is very important in deciding whether or not to move forward on the project in question. Similarly, before undertaking a new project, you have to assure yourself that you can generate sufficient profits in order to meet the profit targets set by your firm. Thus, you might ask yourself, “How many units do I have to sell in order to produce a target income?” You could also ask, “If I increase my sales volume by 50%, what will be the impact on my profits?” This area is called Cost-Volume-Profit (CVP) Analysis. In this discussion we will assume that the following variables have the meanings given below: P = Selling Price Per Unit x = Units Produced and Sold V = Variable Cost Per Unit F = Total Fixed Costs Op = Operating Profits (Before Tax Profits) t = Tax rate Break-Even Point Your Sales Revenue is equal to the number of units sold times the price you get for each unit sold: Sales Revenue = Px Assume that you have a linear cost function, and your total costs equal the sum of your Variable Costs and Fixed Costs: Total Costs = Vx + F When you Break Even, your Sales Revenue minus your Total Costs are zero: Sales Revenue – Total Costs = 0 Breaking Even?

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Chapter 6 Notes Page 2 Please send comments and corrections to me at [email protected]This is the “Operating Income Approach” described in your book. If you move your Total Costs to the other side of the equation, you see that your Sales Revenue equals your Total Costs when you Break Even: Sales Revenue = Total Costs Now, solve for the number of units produced and sold (x) that satisfies this relationship: Revenue = Total Costs Px = Vx + F Px - Vx = F x(P - V) = F x = __F__(FORMULA "A") (P -V) Formula "A" is the “Contribution Margin Approach” that is described in your book. You can see that both approaches are related and produce the same result. Break-Even Example Assume Bullock Net Co. is an Internet Service Provider. Bullock offers its customers various products and services related to the Internet. Bullock is considering selling router packages for its DSL customers. For this project, Bullock would have the following costs, revenues and tax rates: P = $200 V = $120 F = $2,000 Tax Rate (t) = 40% Using Formula “A”, we can compute the Break-Even Point in units: x = 2,000(200 - 120) x = 2,00080 x = 25 units Sometimes, you see the (P-V) replaced by the term "Contribution Margin Per Unit" (CMU): x = __F__(FORMULA "A") CMU